The use of captive insurance companies in risk management has steadily increased over the past decade. However, despite the steady growth of captive insurance companies and the benefits they offer, the captive industry still remains mysterious and not easily understood by those not involved in it.
An element of the mystery surrounding captive insurance is no doubt caused by the fact that a wide range of companies have been organised under the title of ‘captive insurers’. This is because captives can be owned in a variety of different ways depending on the desired end result. Captives can be formed to provide direct insurance as well as reinsurance. They can be owned by a single parent and provide cover for the business of that parent only or they can be owned by multiple owners to insure each other’s risks such as industry captives or even owned by parties not related to the insured, such as insurance agents. Clearly with so many diverse groups forming captives there must be many benefits associated with them, but before explaining them in detail, I believe they will easier to comprehend if the reader has a better understanding of the various types of captives that can be formed.
Some of the more common captives are single parent or pure captives, industry captives, association captives, agency captives, rent-a-captives and segregated cell captives. Single Parent captives, more commonly known as pure captives have a single owner of which the captive provides the insurance coverage. Industry captives are generally owned by companies within the same industry and are usually formed to provide a cover that is either costly or unavailable within the traditional insurance market. Association captives are formed by associations and insure the members of the association, association captives can be owned by the association or by individual members. Agency captives are owned by an insurance agency and provide insurance for the clients of the agency.
A rent a captive is unique in that it will ‘rent’ its surplus to companies that wish to participate within a self insured program but are not necessarily willing or able to capitalize their program. A rent-a-captive will insure the risks of its renters and will often times profit share the income with the insureds. Segregated cell captives are similar to a rent-a-captive structure, however, depending on the domicile and the type of cell (incorporated or non-incorporated) the assets and liabilities of each cell are kept ‘segregated’ from the other cells as well as the core.
The incorporation of a captive insurance company or implementation of an insurance programme provides the benefits of ‘tailor’ made insurance programmes thus reducing a company’s reliance on the commercial insurance market. There are possible favourable tax considerations as well, but most importantly is the ability of the owners of a captive to control their own destiny. In fact ‘control’ is perhaps the single most important reason for forming a captive.
The ability to manage and control the insurance programme including underwriting the risks to be written and determining the amount of risk to be taken, handling the claims process and managing the captive’s investments provide the owners with the opportunity to turn a cost centre into a profit centre. This is further enhanced by the ability to access the reinsurance market which the owner themselves would not be able to do directly as reinsurance companies only deal with insurance companies. The formation of a captive provides direct access to this wholesale market place. This access allows for the sharing of risks, thus reducing the captive exposure to catastrophe risk and allowing the captive to benefit from their owners favourable loss experiences.
The ability for captive insurance programmes to be tailored to insure any risk desired, by its owners, is perhaps one of the greater benefits of a captive insurance company. The formation of a captive allows for the tailoring of insurance on all levels including the terms and conditions of the policies, the setting of the deductibles or self insured retentions, the setting of the occurrence and aggregate limits, the setting of the premiums etc. This type of control over a company or groups’ self insured programme can lead to improved loss control and encourage greater knowledge of the factors that commonly cause losses. The fact that a captive can provide cover that the traditional market may not be able or willing to provide at cost effective rates is a substantial management tool.
If a captive decides to write a policy covering a risk not covered by the traditional market it is usual to seek the assistance of actuaries to determine a fair cost for the exposure to be written in the captive. The implementation of a captive insurance programme sometimes provide certain tax advantages for the parent, insured and the captive itself. For example the accumulation of underwriting and investment income within the captive may be possible on a tax deferred basis and the premiums paid for by the insured may be deductible.
Generally, premium payments to a wholly-owned captive should be tax deductible provided that the captive writes a substantial amount of unrelated business (usually 30 per cent of premium volume). In addition, as long as the captive qualifies as a true insurance company for tax purposes, ie demonstrates proper risk shifting and risk distribution, it can then deduct a “reasonable and fair” loss reserve for unpaid losses incurred. Professional tax advice should always be obtained prior to forming a captive.
Over time the formation of a captive insurance company should reduce the costs of insurance as the captive will capture the profits formerly made by the original insurance carrier, however this will depend on the insured’s own loss experience. It is generally accepted that a captive promotes a heightened awareness within the owners companies causing effective and efficient loss control policies and procedures to be adopted, further reducing the overall costs of the owners insurance programme.
When this happens, it is usual for the captive to maintain favourable loss experiences year after year resulting in the price of the insurance cover being reduced accordingly. This provides additional savings to the owner simply because, if the insurance cover was still being obtained from the traditional market, the premiums would be based on industry standards and market trends, which may be less favourable than the actual loss history of the captive.
Another great benefit of captive insurance companies is the ability of the owner to manage and control their insurance programmes including the underwriting and claims handling process. As the risk of the owner’s business activities is very familiar to them it allows them to review the historical claims information. Then together with their actuaries they are able to analyse their own historical data against market trends and depending on the risk involved, can implement and maintain various analytical tools to help calculate the premiums to be paid to the captive as well as determining future losses enabling them to set specific IBNR (Incurred But Not Reported) losses. Generally this information can be monitored and maintained on a daily basis providing management with an invaluable tool.
Captive insurance companies are also usually free to implement their own claims handling policies and procedures. By controlling the claim process the captive can determine which claims should be paid and which should be denied, not only reducing the time for the processing and payment of claims but also controlling their own claim philosophy.
The successful combination of the previously noted benefits should stabilise the cost of insurance over time in a captive insurance company allowing for more beneficial planning of the organisation’s control functions and financial structure.
Well managed, successful captives should generate investment income on premiums and unpaid loss reserves, reduce losses to the company as a result turning what was an expense of the owner into a profitable operating company. This is often a key factor in the formation of a captive. This income generation coupled with successful management of the claims process, where claims are paid out over long periods of time can be significant and even more so if the captive can access taxed advantage of non tax growth. The profit generated should provide additional funds to pay losses and ultimately reduce the owners’ premiums.
The purchase of insurance on the traditional market does not allow for the control over the investment of the premiums, however the implementation of a captive generally allows for the opportunity to direct these investment choices.
There is no doubt the formation of a captive insurance company is a very effective tool in managing the cost of risk and provides many benefits to their owners, however the formation of a captive must be carefully researched and analysed to ensure the viability of the financial and often times none financial reasons for formation. This is not a short-term solution and owners should be prepared to commit time and resources over a long period of time.